Be Smart - Be a Passive Investor

Author: Ray Prince
One of the first things we come across when we take on a new client is starting to make sense of the collection of policies and investments they have. They are usually in a pile somewhere and tend to consist of many different funds across several providers. Almost without exception, their investment plans include 'active fund manager' investments. The values vary, but £100,000 to £250,000 is not uncommon. A sizable amount, I'm sure you'll agree. We have written many times on this subject - have a risk assessed portfolio - get your asset allocation right (where your money is and in what amounts) - buy and hold etc. Today we thought we would simply look at why we advocate 'passive investments' and not 'active fund management'. After all, the latter is still recommended by most salespeople, banks and commission based financial advisers. To remind ourselves, active fund managers believe they can buy and sell more effectively than their peers to create higher returns, whilst passive investors will accept the return of the market. So, can these active fund managers deliver higher returns for you consistently over the long term? Let's see what evidence there is. In the USA, numerous studies have been conducted to see if this can be achieved. One of the more recent was conducted by Thomas P. McGuigan and appeared in the February 2006 edition of the Journal of Financial Planning. He found that, on average, only 19 percent of the actively managed mutual funds were able to beat their corresponding passive benchmark. This would suggest that a classic buy-and-hold strategy for purchasing active managers would yield a "success" only 19 percent of the time, and that means of course that 81% of the time you would lose. A Canadian study in 2007 by Standard & Poor's showed that typically over five years, less than 10% (8.4%) of actively managed Canadian equity funds beat the TSX index while over three years only 13.3% managed to do so. This means that you would lose circa 9 times out of ten. "Even during turbulent market conditions we continue to see the majority of active fund managers underperforming their relative S&P syle benchmark," says Jasmit Bhandal, director at Standard & Poor's. "In addition, results continue to show that active fund managers lag their passive counterparts over one, three and five years. These results continue over the longer term as illustrated in a paper by Rex Sinquefield called "Active vs. Passive". His paper also took ito account how many funds that started out years ago are still around today. Using a fund data organisation called Morningstar, and looking back 15 years to when there were 10,000 funds, he found that only 100 of these funds still operated! So immediately, his data source was reduced by approximately 90%. He then looked for any funds that outperformed the S&P index over that period. He found that only 14 mutual funds beat the index, and a few of these funds were index funds themselves!' He pondered quite naturally,"would I have been able to select the (few active) managers 15 years ago that would outperform the index? Hardly. Fourteen out of over 1200 is no more than one would expect from chance". Study after study shows that when active funds do outperform benchmark indices, this is down to luck rather than skill and no more than would be expected by random chance. It also usually costs a lot more to invest in actively managed funds, and it just doesn't make sense to pay so much more for random chance. So instead of looking for the needle in the haystack, why not just BUY THE HAYSTACK? The subject of cost also becomes even more important when we look ahead to the future returns you can expect from the stock market. It is generally expected by most commentators that the double digit returns of the 1990's will not be achieved again any time soon. So, as a proportion, costs eat into your returns far far more. This reminds me of a classic saying: "The key to financial success is to understand what you can change, appreciate what you cannot change and have the wisdom to know the difference". The Financial Tips Bottom Line As Ron Ross, Ph.D., writer of 'The Unbeatable Market' in 2002 said - "Active [investment] management is little more than a gigantic con game. ACTION POINT We cannot stress enough the importance of reviewing your investments. If you hold actively managed funds, and the chances are you will, you are far more likely to lose out in the long term. If your adviser has put you into an active fund - ask why! Any answers your adviser gives, or if you have any questions on this subject, let us know - we will give you our impartial view.
Ray Prince is an Independent Financial Planner with Rutherford Wilkinson plc, and helps UK Resident Doctors and Dentists get the best deals on mortgages, protection and investments, as well as helping them achieve their financial objectives. Click here for Financial Advice for UK Doctors and Dentists and to get your free retirement guide, How To Avoid The 7 Most Common Retirement Planning Mistakes. Rutherford Wilkinson plc is authorised and regulated by the Financial Services Authority.